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Asset Allocation Views: Early Cycle Investing

In this abridged version of our latest Asset Allocation Outlook, we discuss the opportunities and risks of investing in an early cycle recovery.
05 January 2021

2020 was an extraordinary year for financial markets. The pandemic was a black swan event that caused the biggest quarterly drop in global GDP and increase in unemployment since the Great Depression, and the drawdown in equity and credit markets was one of the fastest on record.

Yet, if the market meltdown was unprecedented, so was the recovery that followed. We believe the global economic recovery is poised to continue in 2021 and will gain strength once vaccines are broadly deployed and the world starts to return to normal social distancing.

As our latest Asset Allocation Outlook   discusses in detail, we expect profit growth will accelerate, and the improvement in fundamentals should bode well for risk markets and cyclical assets in particular. We remain overweight equities in our multi-asset portfolios and select areas of the credit markets and have added exposure to more cyclically oriented sectors and regions.

To be sure, PIMCO expects the economic recovery will be a “long climb” with hiccups along the way, and it could take up to two years to reach pre-COVID-19 levels of global output. The two key swing factors – virus containment and fiscal policy support – will greatly influence the recovery process.

As a result, we continue to focus on portfolio diversification and resiliency.

Equity versus credit

Increased earnings growth is positive for both equities and credit, but it provides a more significant tailwind for equity markets. This is why, historically, equity markets have generated higher risk-adjusted returns during the early stages of a business cycle.

The Fed’s commitment to overshoot its inflation target is also supportive for equities, which look attractive given what is likely to be an extended period of negative or low real yields.

In addition, with monetary policy constrained by near-zero interest rates in most of the developed world, fiscal policy will need to do the heavy lifting. The size and the scope of fiscal response is bound to have critical implications for both the economic recovery and asset prices.

Equity themes

The recovery in activity and improvement in corporate profits should support cyclically sensitive assets, which have meaningfully lagged market leaders like big tech since the market bottom in March. The global manufacturing recovery should bolster sectors such as industrials, materials, and semiconductors. Focused fiscal stimulus and healing in the labor market should aid personal savings and consumption, benefiting the housing and consumer durables sectors. However, we remain cautious on transportation and hospitality, which could face earnings challenges for several years. From a regional perspective, we expect cyclically oriented equities – such as in Japan and select emerging markets – to benefit from the recovery.

We also continue to seek opportunities in sectors that may benefit from longer-term disruption. These include technology companies, which are supported by strong fundamentals and stand to benefit further from secular trends accelerated by COVID. The U.S. and China remain dominant players in the global technology sector, but we are also looking to take advantage of themes playing out in other regions, such as green energy in Europe and automation in Japan.

Credit themes

Credit spreads have tightened meaningfully since March and April, and while we believe credit is less attractive than equities on a relative basis, we see pockets of opportunity.

Within corporate credit, sectors are recovering at different paces depending on how the pandemic affected them. We are cautious on high yield credit, especially in areas that might face funding needs in the second COVID wave, but we see value in higher-quality investment grade issuers and sectors. We continue to favor housing-related credits (mainly in the U.S.) given strong fundamentals. In emerging market credit, we see attractive opportunities but prefer to take exposure in more liquid instruments.

Key risks, and diversifiers

The major near-term risk is that virus containment efforts hinder the economic recovery.

We believe high quality duration (government bonds) will continue to be a reliable source of diversification against a growth shock despite yields at historically low levels. U.S. Treasuries have more room to rally than most developed market government bonds and are likely to remain the flight-to-quality asset of choice. We also favor select emerging market government bonds, including Peru and China, which offer yield advantage and have tended to perform well during risk-off events.

Another potential risk is an inflation surprise. We expect that inflation globally will remain subdued in the near term as the effects of the pandemic keep the price of goods in check. However, large fiscal injections, climbing government debt, and accommodative central banks could lead to higher inflation in a post-COVID world.

We are focused on assets that can serve as both an inflation hedge and a diversifier in a scenario of weakening economic conditions. This includes inflation-linked bonds and gold, which we believe provides a good store of value over the long term with a low correlation to traditional risk assets. (We discuss gold valuations in this recent blog post. ) We are avoiding more growth-sensitive real assets – such as energy commodities – given our expectations for a gradual economic recovery with meaningful downside risks and low or negative real yields for years to come.

For detailed insights into our views across asset classes, please read our December 2020 Asset Allocation Outlook, READ HERE .


Erin Browne is a managing director and portfolio manager in the Newport Beach office, focused on multi-asset strategies. Geraldine Sundstrom is a managing director and portfolio manager in the London office, focused on asset allocation strategies.

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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Diversification does not ensure against loss.

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